Dolby Laboratories Inc (DLB) 2005 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Dolby Laboratories' conference call discussing fiscal fourth quarter and year-end 2005 results. During the presentation all participants will be in listen-only mode. Afterwards you will be invited to participate in a question-and-answer session. (OPERATOR INSTRUCTIONS). As a reminder, this call is being recorded Thursday, November 17, 2005. I would now like to turn the conference call over to Paula Dunn, Director of Corporate Communications for Dolby Laboratories.

Thank you. Good afternoon, everyone. Welcome to Dolby Laboratories' fourth-quarter fiscal 2005 earnings conference call. Joining me today are Bill Jasper, Dolby Laboratories' President and CEO; Marty Jaffe, Executive Vice President Business Affairs; and Kevin Yeaman, Dolby's new Chief Financial Officer. In addition to Bill, Marty and Kevin, Ed Schummer, Dolby's Senior Vice President and General Manager of the Consumer Division, and Tim Partridge, Dolby's Senior Vice President and General Manager of the Professional Division, are here to participate in today's Q&A.

If you have not already received a copy of our press release with the results discussed here today, you can find it on our website, www.Dolby.com under the Investor Relations section. This conference call contains forward-looking statements within the meaning of section 27-A of the Securities Act of 1933 as amended and Section 21-E of the Securities Exchange Act of 1934 as amended.

These statements include statements relating to our projections for future operating results for our fiscal year ending September 29, 2006; market trends for the industries in which we compete including trends related to DVD player sales and trends in the PC, broadcast, gaming, automotive and AAC-based music device market; our expectations regarding the success of our Digital Cinema initiative; the capabilities and market acceptance of our products and technologies and our ability to compete successfully in our market.

These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause results, whether specific to Dolby or related to the entertainment industries in general, to differ from those expressed or implied by these forward-looking statements. Important factors could cause actual results to differ materially from those in the forward-looking statements including risks associated with whether the markets for consumer electronics products, PCs, gaming products, automobile entertainment systems and other products that incorporate Dolby's technologies will grow and develop as we anticipate; competition risks; risks associated with the health of the motion picture industry, and risks associated with the development of the Digital Cinema market generally and Dolby's Digital Cinema products specifically.

Other equally important factors that could cause actual results to differ from those in the forward-looking statements are included in the risks identified under the section captioned "risk factors that could affect future results" in Dolby's Securities and Exchange Commission filings and reports including our quarterly report on Form 10-Q for the quarter ended July 1, 2005 and filed with the SEC on August 11, 2005. Dolby disclaims any obligation to update information contained in these forward-looking statements whether as the result of new information, future events or otherwise.

In this call we will describe certain pro forma financial measures which should be considered in addition to and not in lieu of comparable GAAP financial measures. Please refer to our earnings release for the fourth quarter of fiscal 2005 and year-end results on our website at www.Dolby.com under the Investor Relations section for the most directly comparable GAAP financial measure and related reconciliation.

As for the structure of this call -- Bill will begin with the highlights of the quarter; Kevin will follow with a rundown of Dolby's financial results; and Marty will follow with a discussion on the near-term trends we are seeing in the marketplace before offering 2006 guidance. So with introduction behind us I'll now turn the call over to Bill.

Thank you, Paula. It Dolby made progress on three important fronts toward its long-term objective of being an essential element in the growing and broadening array of entertainment technologies. We expanded our marquee brand, we extended further into new markets and we broadened our management team. I'd like to spend a few minutes talking about each of these accomplishments.

First, Dolby continued to grow its brand by demonstrating its leadership in Digital Cinema and in broadcasting. We just completed the largest single deployment of Digital Cinema to date with the installation of 84 Dolby Digital Cinema systems in 38 U.S. markets coordinated with Disney's release of Chicken Little. Dolby's Digital Cinema equipment is now being used in over 100 theaters worldwide and by 22 theater chains in the U.S. alone. Having made an investment in Digital Cinema to jump start the industry, we are now clearly seen as a leader in the new frontier of Digital Cinema.

And we were awarded a coveted primetime Emmy for outstanding achievement in engineering development for Dolby eAudio coding technology which has helped the television industry bring 5.1 surround sound programming to DTV and HDTV viewers.

Second, Dolby further extended into new markets. In last quarter's earnings call we mentioned that the European broadcasters union recommended inclusion of 5.1 audio decoding in new televisions and set-top boxes that receive HDTV signals in Europe. In the fourth quarter the first three European pay TV broadcasters to launch HDTV announced all will be featuring Dolby Digital 5.1 on their channels as an integral part of their services.

We also saw the launch of an HDTV service by another mainstream broadcaster in Europe, ProSiebenSat, and it will feature Dolby Digital as the sole audio broadcast. This means that Dolby technology will be featured in every receiving set-top box for the high-definition services of Sky in the U.K., Canal Plus in France, and both Premier and ProSiebenSat in Germany.

At the Custom Electronic Design and Installation show, or CEDIA, we demonstrated Dolby True HD along with Dolby Digital Plus. Which builds on the mandated Dolby Digital technology in both Next Generation DVD formats. With Dolby True HD viewers experience true lossless multi-channel surround sound that fully complements the detail and fidelity of the high-definition picture. Working through motherboard manufacturers we expanded our PC entertainment experience program with Intel to include systems integrators to ensure that we benefit from this growing channel.

In our Via subsidiary we have seen momentum beginning to build in the 802.11 program with the addition of LG Electronics as a licensor and Via continues to benefit from AAC royalty collection due to the popularity of Apple's iPod. Prologic 2 technology will be offered in the all-new Volvo C70 with the addition of Dolby audio technology as an available option for Volvo C70, Volvo's entire 2006 line of cars will allow customers to choose Dolby Prologic 2 and enjoy a home theater like experience on the go.

And in our professional division we are collaborating with Walt Disney Studios through our Cinea subsidiary. Disney announced it would utilize Cinea's state-of-the-art encryption technology for its 2005 academy of motion arts pictures -- motion picture arts and sciences Oscar candidate screeners. This technology provides copy protection and piracy tracking for DVDs.

In addition we just announced today that Microsoft's new Xbox 360 videogame and entertainment system will support Dolby Digital surround sound for both games and movies. The Xbox 360 will include both interactive 5.1 surround sound for gameplay as well as Dolby Digital decoding for video playback.

And finally, we broadened Dolby's management team. I'm very pleased and excited to welcome Kevin Yeaman as Dolby's new Chief Financial Officer. Kevin brings over 15 years of strategic and business financial management experience including serving as the CFO for another publicly traded company for the last five years. Kevin is a great addition to the Dolby team. With that introduction I'd like to welcome Kevin and turn the call over to him to discuss our financial results for the fourth quarter and year-end. Kevin.

Thank you, Bill. I'm glad to be on board. Before I turn to the financial results I would like to briefly reiterate two aspects of Dolby's business that you should take into account. First we believe pro forma financial results for prior periods are meaningful to investors because they reflect the Company's financial position on a go-forward basis subsequent to the completion of Ray Dolby's contribution of intellectual property in February 2005.

Second, we license our technologies to consumer electronics manufacturers and software developers who use them in our products. Our licensees are required to report to us between 30 and 60 days after the end of the quarter in which they ship their products. And since licensing royalties comprise roughly three-quarters of our revenue, our overall revenue can fluctuate quarter-to-quarter as a result of the timing of our receipt of those royalty reports. In addition, it is not uncommon for royalty reports to include corrective or retroactive royalties that cover extended periods of time. This could cause our results to vary from forecasts.

Since I have only been with Dolby for a few weeks now, I'm going to provide the financial results at a high level this quarter and Marty will provide you with more detail. I'm going to focus primarily on the results of the fourth quarter, though I will also summarize the full-year results at the revenue and net income level. With that I will now turn to the financial results.

Revenue for the fourth quarter was $78.9 million, up 15% year-over-year. On a full-year basis Dolby's revenue was a record $328 million, up 13% from fiscal year 2004. Revenue mix for the quarter was 74% licensing and 26% product sales and production services.

In the technology licensing segment revenue increased 19% year-over-year in the fourth quarter and by 17% for the full year. Although revenue from our consumer electronics market was roughly flat year-over-year, we saw strong year-over-year growth from all of our other technology licensing markets which includes PC, broadcast, gaming, automotive, and Via revenues.

In our products and services segment revenue for the fourth quarter was up 3% year-over-year and up 5% for the full year as soft demand from theaters due to an overall weak box office and theater consolidation was offset by strong demand from European broadcasters for Dolby Digital 5.1. Let me turn to the details of the P&L for the fourth quarter.

Total gross margin was 81% of revenue for the quarter, down 1 point sequentially. Licensing gross margin standing at 91% for the fourth quarter ticked down 1 point sequentially due to the technology mix. Product gross margins declined to 47% for the quarter, down 3 points sequentially.

The primary reason for this decline is, as we mentioned earlier, Dolby equipped 84 theater screens with Dolby Digital Cinema systems in connection with the release of Chicken Little. Dolby funded the bulk of the equipment and installation costs related to this deployment resulting in a fourth-quarter charge of approximately $1.4 million reflected primarily in cost of product sales.

Going forward with Dolby expects to recognize a similar charge in the first quarter of 2006 of approximately $7 million of which approximately $6.5 million will be reflected in cost of product sales and approximately 500,000 in cost of services. We believe this upfront investment has established Dolby as a widely seen leader in Digital Cinema. In addition Dolby expects to receive virtual print fee payments from participating Studios.

Services gross margin was 60% for the fourth quarter, up 1 point sequentially. SG&A expense was 42% of revenue in the fourth quarter which was flat sequentially as a percentage of revenue. Note that after growing from a quarterly run rate of about 20 million in the first quarter of 2004 to about 30 million in the fourth quarter of 2004, the SG&A line has remained steady at a range of about $33 to $35 million per quarter throughout fiscal year 2005.

R&D was 10% of revenue for the fourth quarter, up 1 point from last quarter as we continued to invest in our development team and strengthen our expertise in digital imaging technology. Other nonoperating income was $4.1 million in the fourth quarter and 7.2 million for the fiscal year versus an expense of 500,000 and income of 200,000 in the fourth quarter and full year of 2004 respectively. Of course, the increase is primarily due to interest income as a result of our larger cash balance. But other income for the quarter also includes approximately $1.4 million in foreign exchange gains.

Let me explain this item in a little more detail. During the year we began selling more products denominated in U.S. dollars from our U.K. office. We have maintained the U.S. dollar receipts from this business in a U.S. dollar account in the U.K. which has grown during the year. This has exposed our P&L to foreign exchange gains and losses. During the first quarter we will take steps to reduce this exposure significantly, most likely by converting the U.S. dollars to local currency. Going forward we do not expect to incur significant foreign exchange gains or losses.

Another note on other income. Since the acquisition of Lake Technology we have been accounting for that subsidiary on a one quarter delay which is allowed under GAAP. We are planning to begin accounting for Lake on a true quarter basis beginning in the first quarter of 2006 which will result in a catch-up adjustment. This adjustment will result in an expense of approximately $1 million which will be reflected as a nonoperating expense in the first quarter of 2006.

Moving to tax, we were using an estimated rate of approximately 43% during the first three quarters of 2005. Our actual tax rate for fiscal 2005 came in at 41%. The true-up in the fourth quarter resulted in an effective rate for the fourth quarter of 35%. Fourth-quarter net income in 2005 was $16.8 million or $0.15 per diluted share compared to $3.3 million or $0.03 per diluted share for the fourth quarter of fiscal 2004. For the full year net income was $52.3 million or $0.50 per diluted share compared to $39.8 or $0.43 per diluted share for fiscal 2004.

On a pro forma basis, which gives effect to Ray Dolby's intellectual property contribution in February 2005, fourth-quarter net income in 2005 was also $16.8 million or $0.15 per diluted share compared to 9.6 million or $0.10 per diluted share in the fourth quarter of 2004. For the full year net income excluding Ray Dolby's intellectual property contribution was $63.4 million or $0.61 per share compared to $63.3 million or $0.68 per diluted share for fiscal 2004.

Net income also includes stock-based compensation charges of 2.7 million for the fourth quarter of 2005 and $2.4 million for the fourth quarter a year ago. For the full fiscal year 2005 stock-based compensation was $14.2 million versus $6.8 million in 2004. Per share calculations are based on 110.5 million diluted shares in the fourth quarter of 2005 compared with 96.8 million diluted shares in the comparable year ago quarter. For the full fiscal year per share calculations are based on 104.2 million shares for 2005 compared to 92.8 million for fiscal 2004. The increase in shares is principally attributable to the shares sold by the Company in its February 2005 IPO.

Turning to the balance sheet, Dolby finished the year with $372 million in cash and equivalents. From operations we added $14 million during the fourth quarter and $77 million during the full year. Now I'd like to hand the call over to Marty.

Thank you, Kevin. Thanks again to all of you for joining us today. I would like to spend the next few minutes focusing on some of the trends we are seeing in the industry. First, in the DVD portion of our licensing segment we continue to see a slowdown in the growth of traditional consumer DVD player sales reported by licensees and slower than anticipated adoption of DVD recordable players. Some manufacturers are also continuing to reduce the complexity of their low-end DVD players which reduces the number of processors on which Dolby earns licensing revenue.

Another trend that we are seeing continuing is a movement by discount retailers towards lower end Chinese made DVD players. To be clear, we believe that in the long run China represents an opportunity for Dolby given China's rapid growth and its large and under penetrated consumer market. In the near-term, however, China is posing challenges in royalty collection for Dolby and it remains a top priority.

Before giving you a better sense of the makeup and performance of our consumer licensing segment, let me say that we are encouraged by the expansion that we are seeing in new and growing markets such as PC, broadcast, gaming, automotive and AAC-based music devices. Let me go into more detail.

First, consumer electronics, which is our largest market, typically represents around 50 to 60% of our licensing segment in any given year depending on the makeup of our royalty collection. In 2004, CE was slightly above the high end of this range. While in 2005 we are closer to the low-end. This decline as a percentage of licensing revenue is partly due to the trends I just mentioned, but the primary factor is Dolby's strong push into other growing markets such as PC, broadcasting, gaming, automotive and AAC-based music devices such as the Apple iPod.

DVD-related products make approximately three-quarters of our CE market. Dolby's biggest market after consumer electronics is personal computer which represents around 25 to 30% of our licensing segment. Growth has been strong from this market based on demand for software DVD players which make up the vast majority of the PC business.

The balance of our licensing revenues derived from the broadcast, gaming and automotive markets as well as from our Via subsidiary. These markets continue to diversify Dolby's revenue stream and are showing strong growth fueled by demand for multi-channel Dolby Digital and set-top boxes and televisions, new game consoles, the growing trend by auto manufacturers to include Dolby technologies in new cars, and the strong growth in Apple's AAC-based iPod.

Finally, I'd like to spend a few minutes talking about Digital Cinema. As Kevin mentioned, the initial cost of our Digital Cinema initiative with Disney has affected and will affect our product and production service gross margins in the near-term. We see this is an important investment in our future as it further positions us as a technology provider across the entertainment industry. The debut of Star Wars Episode III and now Chicken Little in 3-D marks Dolby's successful entry into Digital Cinema.

As Bill said today, over 100 theaters worldwide and 22 theater chains in the U.S. alone are equipped with Dolby's Digital Cinema product offering. Chicken Little grossed $40.1 million in its opening weekend and for the same weekend eight of the top ten grossing theaters in the nation for any movie were Dolby Digital Cinema sites. Furthermore, in the opening weekend theaters showing Chicken Little in 3-D and on Dolby Digital Cinema equipped generated equipment generated more than twice the gross on average as those that showed Chicken Little on standard 35mm film projection technology.

Now let me turn to our initial guidance for 2006. While we will be providing guidance for projected financial results for future periods on this call, it is our policy not to provide any further guidance or updates on the Company's financial performance during the quarter including confirming guidance that has previously been given unless we do so in a press release, SEC filing or other publicly available communications.

Furthermore, an aspect of our business model that we want to continue to stress is the lack of a predictable quarterly pattern in our results. Our revenues are lumpy. Different quarters are higher in different years.

For fiscal 2006 revenue is currently expected to be 335 million to 360 million. Net income for fiscal 2006 is expected to be between 53 million and 65 million. Earnings per diluted share for the full year 2006 are expected to be in the range of $0.46 to $0.56. We expect diluted number of shares to be approximately 115 million for 2006. While under FAS 123R stock-based compensation may vary based on factors such as stock price or volatility, we currently expect stock compensation for the full year to be between $19 million and $21 million.

This concludes our prepared remarks. Now I'd like to turn it over to the operator for questions. Please go ahead, operator.

(OPERATOR INSTRUCTIONS). Steve Frankel, Adams Harkness.

Bill, I wonder if you might tell us a little more about the Q1 Digital Cinema rollout and how many screens are implied by that charge you talked about during your comments?

I think you're referring, Steve, to the $7 million charge we'll take in the first quarter?

Yes.

That really represents the remainder of the Disney rollout. In other words, as of September 30th we had only shipped a small percentage of the total installations and thus we only booked the loss pertaining to those sites which had actually shipped and we installed. The rest of those came in October, in time for the November 4th opening. And to the charge is related to those screens installed basically up until November 3rd that we're taking the charge in the first quarter.

Where are you in your plans to have agreements with additional studios so that you can put content other than Chicken Little through those screens?

Let me let Tim answer that.

Right now, Steve, we're expecting to see Harry Potter on a few screens. There were no (sic) Narnia from Disney will be on the a few screens. So we've got commitments of a number of films and we're still in negotiations for long-term commitments with all the studios.

Great. I'll let somebody else ask a question and come back to you later.

Ralph Schackart, William Blair & Company.

Good afternoon. Good job on the quarter, but my question relates to guidance going forward. It was on the low-end -- certainly lower than we were looking for fiscal '06 and could you just talk generally? Is that just conservatism on your part and perhaps you could give a sort of a little bit of visibility and what you think about licensing growth for next year?

Let me give you a little more color to that. The production sales and production service portion of our business we're seeing flat to slightly up. And most of the growth we're expecting to see is in our licensing revenues. And with licensing in the CE market the industry analysts are expecting consumer DVDs to be up between 10 and 15%, but we're seeing it flat and we're forecasting flat to slightly down in the CE segment market. And we expect our growth in licensing revenue to be split roughly evenly between our PC market and the other three markets.

Thank you.

Hunter DeBose (ph), Morgan Stanley.

I was wondering if you could give some more clarity around your longer-term Digital Cinema strategy and just give an update on where things are? We've seen a number of announcements in the last couple of months about sort of several thousand screens -- build outs from some of your competitors in that sector. And I'm just wondering what we were looking forward to next year and the year ahead from Dolby?

Well, we expect to be a major player in Digital Cinema. Obviously we've made a big investment in getting things started with Chicken Little. We have been discussing with all the other parties that are announcing their rollout plans in terms of providing equipment and services to those particular initiatives. We're continuing those discussions. We believe that we will be successful in getting our equipment deployed throughout the Digital Cinema rollout. But you have to remember that just announcing that somebody has an agreement with a studio and they're going to rollout x-thousand screens doesn't really mean it's going to happen.

One thing we discovered with the rollout of Chicken Little that getting Digital Cinema out there is extremely complex. We had over 50 installers out there working to get our 84 sites installed in time for Chicken Little and we discovered an immense amount of -- discovered huge problems, solved them, gained a great deal of expertise. The gating factor in rolling Digital Cinema out right now is really -- as we speak today is the supply of projectors.

We had wanted to do 100 screens for Disney with Chicken Little, we settled on 84 because we could not get any more digital projectors. Going forward we think that this is going to be a problem. We've talked to the manufacturers. They are gearing up to produce some more projectors. But if you try to do a couple thousand in 2006 there's going to be a severe supply problem not only for projectors but if you look at the fact that all the lenses for these things come from one manufacturer -- there's a supply problem with lenses.

So we're working behind the scenes with all the parties, all the initiatives and we think that we will be a major player going forward. Tim, do you want to add anything?

Only that other than the lack of projectors and also the lack of trained people to install Digital Cinema right now they are, as Bill says, two bottlenecks and to doing major rollouts as we've discovered. There's also the issue of DCI compliance. Which is that everybody is hoping and expecting that these systems will meet the studios' requirements. Well the studios' requirements, as you all know, were released this summer. However, those requirements have now got to be embedded into industry standards so that is going to take some time. So it's not going to be until later in 2006 that anybody will be able to truly say they are DCI compliant and adhere to those standards because those standards have not yet been written.

Anthony Noto, Goldman Sachs.

This is actually Ingrid for Anthony. I have a question regarding your comments about DVD player shipment growth. Is that mainly due to just -- I'm sorry, you had said revenue? I was just wondering, is that purely because of a change in shipments or is that due to a change in licensing fee?

I think it's a combination. I think what we said in our comments were that we're seeing both a shift in the make up or the complexity of the products, so we're seeing movements from more complex products to lower cost, lower complexity products which does have an impact on our ASPs. We're also seeing some maturation in the marketplace.

Okay, thanks.

Daniel Ernst, Hudson Square Research.

Thanks for taking the call. So one primary question, then I've got a follow-up. Could you give us a sense of the breakout between traditional CE, the DVDs and home theater boxes and surround sound receivers, for instance the emerging market, and then how do you see that playing out in your guidance? Is it 75/25 today going to 60/40 next year? Can you give us sort of a rough order of magnitude of how that breaks up? And then I have a follow-up. Thanks.

The only breakout we gave is what Marty gave before and that's 50 to 60% on the CE business, 25 to 30% on the PC business with the other three categories being the remainder. And we talked about where we were in 2005 on the CE market which was toward the end of the top end of that range -- 2004 was the top end, 2005 was edging toward the low-end. And going forward we expect to see it in that range.

Understood. And so then in your guidance for fiscal '06 and then your thinking beyond, when do you see some of your growth initiatives like Dolby headphone and automotive making up a material share? And then likewise, when do you in your industry discussions find next gen DVD players making inroads into the revenue line?

Well, as we indicated, we're seeing some good strong growth in the other markets other than CE and we expect that to carry forward. I think one thing that we want to continue to emphasize is we see this as a positive move in terms of diversifying our revenue sources. Obviously DVD has been an extremely important element of our business, but we're excited about the possibility of all these other segments growing faster than that market in terms of diversifying our revenue sources. I'll let Ed talk to future generation HD and DVD -- Blu-ray.

Yes, you know the impact of those things, when it's actually going to happen is anybody's guess. You probably read in the press about all the various delays that are happening in conjunction with HD DVD. Blu-ray, if you look at what some of the predictions are, it may be that actually the end run around the introduction of that will actually come through a game console rather than an actual player. We cannot make any predictions about the release dates of some of our licensees products, but we certainly look forward to that format to making a contribution sometime starting in 2006.

Thank you. And just one clarification, on the competitive landscape, on DCI, are you aware of either at present a DCI compliant server that competes with yours?

No, as I said, there are various parts of the DCI spec that have not even been standardized yet. So there's a lot of work to do within the standards bodies before anybody can claim full DCI compliance.

Okay. Thank you, sir.

Paul Coster, JPMorgan.

Good afternoon. I just want to make sure I've understood what is and is not in the EPS guidance. There are sort of three things that I'm curious about, Kevin and Marty. The first is the Lake catch-up that's included I assume. The second is the $7 million of investment related to the D-Cinema initiative and that's also I assume included. But I'm assuming that FAS 123 related expenses are excluded. Can you comment on those three and I've got a follow-up?

This is Kevin. You're correct that the charge for Lake in the first quarter and the $7 million charge is included in our guidance. You should also know that we provide guidance including the effects of stock-based compensation. So we provide the amount of stock-based compensation that we expect, but the $0.46 to $0.56 is after taking account of stock-based compensation.

Including options as specified in FAS 123?

Yes, that's correct.

Okay, got it. And then the follow-up question is -- I've got several but I suppose I'd better focus on the Digital Cinema Initiative. What exactly is it that Dolby is providing and what is the sort of dollar value of that once this business normalizes? And what share of the overall cost per screen to you think that you're seeing?

Well, what we provided in the Chicken Little rollout was the full system integration service. We purchased the projectors and installed the full system obviously using our own hardware that we manufactured together with our third party projectors. In the other deployments that we expect to also participate and take a lead in we'll be looking just to sell our products as we normally do into other people who are being the system integrators.

Okay, Tim, I just want to make sure I understand it. It's the audio and the video that's being stored on Dolby's hardware, is that correct?

Exactly. The server we provide stores and decodes the audio and the video and feeds it to the projector. But we've also provided lots of services this last year for Digital Cinema in terms of mastering and packaging the vast majority of the films that have been released and we certainly expect to maintain that leadership position in our services business.

And what dollar value out of the total cost per screen which is widely estimated at $80,000 to $100,000 per screen?

We're at about 20% of the overall cost in terms of the server itself.

Got it. Thanks.

(OPERATOR INSTRUCTIONS). Chris Kincaid, America's Growth Capital.

I was just wondering how we should think about your per unit royalties as a mix of platform shift in fiscal '06?

Well we don't breakout our per unit royalties in any segment. That can vary based on the mix of our licensee's production, based on the mix of the complexity of our licensees. There is a cost of living factor which changes that each year. So there are a number of factors which go into the actual average selling price and I think as we've seen over time that can go up one quarter, down the next quarter and it's extremely hard to try to pinpoint what's going to happen with that average let alone than break it down into these three different areas.

Okay. But on a blended basis can you give any sort of a directional indication?

We don't give any breakdown in terms of averages per product other than to say that the average for all products is under $1.

Okay. And than I was wondering if you could comment a little on any progress you're making with mobile handset manufacturers and the adoption of Dolby technology for handsets?

Chris, the mobile handset manufacturers are increasingly looking at entertainment type of technologies to enhance the utility of their sets. To date most of that activity has been centered around the AAC technology that we participate in and the patent pool that's administered by Via. Interest has been fairly high and you've probably also seen the press release of the Motorola phone providing iTones functionality. So we certainly see that as being an area of future growth.

Okay, great. Thanks a lot.

Ricky Sandler, Eminence Capital.

I'm still a little confused on the Digital Cinema. You talked about a $1.4 million charge this quarter and a $7 million charge for the first quarter of next year. Is there zero revenue that you're recognizing in both of those periods and only expense? And if that's the case just sort of walk us through the long-term revenue model here? How do we hope to generate revenue from this?

In the fourth quarter we had the $1 million plus expense and no revenue. In first quarter, this December quarter we're currently in we'll have the $7 million charge representing the cost of -- basically the cost of equipment. And we will be receiving some revenues from virtual print fees from Disney.

We have a long-term agreement to receive additional virtual print fees over the next few years on our equipment, basically 10 years. And we expect as we enter into agreements with other studios that we will have those revenue sources from virtual print fees coming in as well. But the way the deal was structured we needed to take the expense up front and the revenues come later.

And maybe could you talk about what -- give us some parameters on the virtual print fees, sort of per movie or some parameter to understand a couple years out what kind of revenue do we generate in this business?

Well, I think the virtual print fees that you've seen thrown around in various press releases are about what we're getting. We aren't under confidentiality agreements aren't disclosing details, but suffice it to say that those virtual print fees are in the neighborhood of what the studios currently pay for 35mm print. And various articles out there and press have talked about $1000, for instance, as being that cost. So we're in the ballpark.

So you might get $1000 per screen that the film is shown on and that's sort of a onetime fee for each of the screens it's shown on?

Yes. So if it opens up on two screens on a multiplex at the same time we get two virtual print fees.

Got it. And then so what we hope is in three to five years we've got lots of studios releasing lots of films on this platform and we're getting fees from a number of films on a consistent basis? C

Correct.

Okay, thanks.

We'll take a follow-up question from Ralph Schackart, William Blair & Co.

Yes, just two quick questions. First, just so I understand the charge in Q1 '06. Should we think about a total product cost in Q1 '06 of 7 million or will that 7 million charge be in addition to the normal gross margin cost in the quarter? And secondly, you talked a lot on the last call about enforcement activity in China. I was curious if you could give us an update on how that enforcement activity is going and if it's going well could that potentially give some upside in the licensing growth next year? Thank you.

As to the first piece, the 7 million is the total cost of equipment. As to the second, I'll let Ed answer that.

Yes, the China activity. One of the issues that we're obviously facing is that as a public company the methodologies we employ to go after these people are somewhat more limited than they were when we were a privately held company. Nevertheless we've started to do some audits of some of our implementation licensees and some of our system licensees. I can't say too much about it because some of the work has not been completed, but so far we're satisfied with the results and we look forward to better being able to enforce our rights in China in the future.

Steve Lidberg, Pacific Crest Securities.

With regards to the level of recoveries, what did you see during the quarter -- or retroactive royalties? And then as a follow-up on the -- actually that's it for now. Thanks.

We don't disclose any recoveries because, as we've said in the past, those are generally immaterial on a quarter-by-quarter basis. Should we ever have a significant material amount we would disclose that separately. But every quarter we do have recoveries and adjustments coming from many licensees. In fact those adjustments can go up or they can go down as licensees adjust their royalty statements for prior quarters.

And a quick follow-up. With regards to the Accounts Receivable, can you talk to the sequential increase there? Thanks.

The sequential increase in Accounts Receivable relates to the Via licensing business. A general increase in business activities resulted in an increase of $25 million. Keep in mind though that most of those collections are turned around and paid out to the participants in the patent pools and so you'll see a corresponding increase in accrueds.

Thank you.

Rajit Thomas (ph), Tracer Capital.

Thanks for taking my question. Could you please let us know in what line item you'll be recognizing the virtual print fees? And my second question is if a theater were to install a system like Avica's, my understanding is it still needs to be capable of reading the Dolby sound system. So in that case will they be paying you a royalty fee just like a DVD recorder or a DVD player manufacturer pays your royalty fee?

This is Tim, I'll take the first question which was about the VPS. We'll be recognizing those in production services.

Okay.

The second question, if you could please repeat it regarding the --.

Yes. My question is right now in a screen if the sound system is tied to the system it recognizes, so a Dolby sound system decodes only Dolby while a DTS sound system decodes only DTS, while in the future in a digital environment you could have an Avica system decoding Dolby sound or a Dolby system decoding maybe DTS sound -- I'm not sure if that happens. But so when -- if a theater was installing an Avica system that is decoding Dolby sound, will you be getting royalty revenues or licensing revenues from the manufacturer of that system? Because it needs to be capable of decoding Dolby sound?

Yes, I'll take that. The sound that has been specified by DCI for Digital Cinema is not anybody's proprietary sound system. So it is not Dolby sound and it won't be anybody else's sound for Digital Cinema. So as you say Avica, Dolby and other people could be decoding this sound which is specified by DCI.

And so does that mean that the theaters will still have to encode in Dolby for DVD distribution but not necessarily for cinema distribution? So for a movie producer who intends to make a movie just for digital screens doesn't need to pay Dolby anything then?

Well, for a long time to come there will be movie theaters that are still playing 35mm film. So they will still be making Dolby sound tracks we believe for many years to come somewhere in the world. And yes, beyond that, when the film goes to consumer media they will also continue to encode that soundtrack with the Dolby format.

And to have to remember that we have the Digital Cinema mastering program which we set up in two of our locations. And as Tim mentioned, most of the films that have been done in digital format in the last year have been mastered by us. So we've been participating in that revenue stream.

Okay, thank you very much.

Eric Mentz (ph), Eagle Asset.

Congrats on a really nice quarter there. Hopefully we're going to see a trend of these. I have two questions. One on the '06 guidance. What is the tax rate that we're going to be using now on net income? And then secondly, with the large cash balance do you guys have any plans for M&A opportunities perhaps?

I'll take the first question. As we said on the call, we were using an estimated rate of 43% for the first three quarters and came in at 41. We think low 40s is the right rate to use going into '06.

As to the cash balance, we are continuing to look for possible strategic alliances/investments very similar to what we've done in the past with the Cinea Demographics and Lake. We have done a number of we think exciting areas that we can continue to expand the Dolby franchise into. As we've already talked in the past we're looking at areas such as the imaging business. We've got an extensive group of people looking there.

And we're also looking at other possibilities for rollouts of Digital Cinema. As you probably know, the business model works slightly differently in Europe where the theater owners in Europe are more willing to put up a percentage of the cost of systems over there, so we're taking a hard look at putting some of our cash to use in terms of pushing Digital Cinema along over there as well as perhaps some more in the U.S.

Sounds good. Thanks, guys.

Paul Coster, JPMorgan.

Two, I'm afraid. The first one is the $7 million of charge in the beginning of '06, why isn't it being capitalized if you're then recovering the cost on a virtual print fee basis is the first question?

Well, I think the simplest answer to that in accounting terms is that we are selling the equipment to a separate party from the party that we're going to receive the virtual print fees from. And so since we no longer own the equipment as an asset or at least under accounting -- in accounting terms we don't, we cannot capitalize it as an asset.

We have separate agreements with the cinema operators versus the studios and those are not linked.

Who owns the asset then?

We do.

So sorry, let me clarify (multiple speakers). Under the accounting rules given that they have an option to buy the equipment at the end of the lease, it's treated as if we don't own it. I think the other important point here is that of course the virtual print fees are contingent on the release of films and under the accounting rules it would be difficult to include that into the accounting for the initial transaction.

It sounds quite complex.

It is.

The second question is I just want to go back to the China comment, I was trying to figure out whether you meant that there's a big catch-up pending with respect to Chinese manufacturers if you get this right. Or whether you're going back to the Chinese OEMs in order to try and encourage them to use Dolby and be more sophisticated in the kind of application. Is it a combination of those two or is it primarily just the catch-up on licensing that's owed you?

You're quite right, Paul. I mean first of all, we look at China as a big opportunity for Dolby in the future. And so in the long-term we want those people to be our customers. We want them to be our licensees. So the way in which you go after catch-up payments and enforcing your rights must be modified with the thought that you want to continue to do business with these people in the future. So we try to take a balanced approach in that.

So some of them are producing product that's just simply -- it's not using Dolby or anything else for that matter, it's just not high-quality solutions and you want to nudge them up sort of the quality curve, is that correct?

Well, if it's a DVD player, Paul, it's got the Dolby Digital decoder in it.

Yes of course. Thank you.

Paul, if I could just clear it up, you're absolutely right, it's complicated -- the Digital Cinema investment. But essentially after ten years the title of the equipment transfers to the theater owner and the accounting rules were such that because -- as Bill said, because the two agreements, the one with the theater owner and the ones with the studios are completely separate, we can (ph) tie those revenue to the expenses.

Got it. Thank you.

Steve Lidberg, Pacific Crest Securities.

As you look at the 40 to 50% increase in stock-based compensation, what are your assumptions behind that increase? Is that primarily volume of stock options or other factors?

Well, the most significant factor is moving to FAS 123 as revised. And so whereas previously the charge was calculated as the difference between the exercised price and our pre IPO accounting valuation, going toward we're using the Black-Scholes model and that's a higher number on the options we've come into the year with. A smaller portion of the charge is related to options that we may issue in the coming year.

Thank you. That helps.

Hunter DeBose, Morgan Stanley.

Sorry, just some clarification around the accounting for your Digital Cinema project. Could you clarify first of all where the expense for supplying the equipment is going to be booked and which business unit? And also, I think you said the print fees will be going into production services. Could to also clarify that please? And second of all, if you are retaining the ownership of the assets for ten years, where on the balance sheet will they appear?

The cost is included in cost of product sales and, yes, the VPFs are included in services revenue -- product services revenue. And again, for accounting purposes the assets are not shown on the balance sheet.

Even though Dolby does retaining ownership of them?

That's right.

Where walking through the capital lease rules here.

Okay, thank you.

I just might mention overall that this is obviously a very conservative approach to accounting for this whole transaction, but it's what we're required to do and we think that in the long-term it's appropriate.

Paul Coster, JPMorgan.

I'm so sorry. You're going to hate me by the time this is up. But on the FAS 123 I just want to -- going back to the last gentleman who asked a question just now -- clearly there's an incremental expense associated with going to FAS 123R. Is it the full 20 million or $0.20 per share? And if it's not the delta is how much of that $0.20 per share approximately?

Well, we guided to 19 to 21 million for the year. You can see that our run rate coming out of '04 was 10 million. There's an increment of approximately 6 million that is due to the new accounting rule. The additional increment is an estimate based on options and -- estimated options and ESPP activity in the current year.

That's excellent. Thank you.

At this time there are no further questions. I'd like to turn the call back to Mr. Bill Jasper for the additional or closing remarks.

Great. Well, I want to thank everybody for joining us on today's call. And just to let people know that Marty, Kevin and I look forward to meeting with many of you in the near future in order to introduce Kevin to you and talk more about our business. Thank you for calling.

This does conclude our conference call for today. We do appreciate your participation and have a great weekend.